The Case of the 1986 Tax Reform Act* RONI MICHAELY^

This paper analyzes the behavior of stock prices around ex-dividend days after the implementation of the 1986 Tax Reform Act that dramatically reduced the differ-ence between the tax treatment of realized long-term capital gains and dividend income in 1987 and completely eliminated the differential in 1988. We show that this tax change had no effect on the ex-dividend stock price behavior, which is consistent with the hypothesis that long-term individual investors have no signifi-cant effect on ex-day stock prices during this time period. The results indicate that the activity of short-term traders and corporate traders dominates the price deter-mination on the ex day. THE 1986 TAX REFORM Act (TRA) was the most dramatic change in the U.S. tax code during the past 40 years. It eliminated the preferential tax treatment of long-term capital gains which was adopted in 1921. Dividend income and realized capital gain income are now treated equally for tax purposes. Using the change in the tax system, this study offers new evidence about th